One primary goal of investing is to earn gains. It doesn’t make sense to invest with an intent to lose money (in most cases) so safeguarding earnings is often a key priority. When an investor can sell an asset for more than the basis (what they paid for it and any adjustments), that is a capital gain. If the investor holds the investment for less than one year, the gain is short term, and the IRS will tax it at the investor's ordinary income rate. If the investor holds the asset for one year or more, the gain is considered long term and the tax rate is lower. However, investors can employ specific strategies to reduce and defer their capital gains tax obligations.
Assets held in retirement accounts are typically not taxed
Investors who sell stocks or other assets within their tax-advantaged retirement account can typically reinvest gains without tax consequences. As long as the funds or new assets stay in the retirement account, transactions such as buying and selling stock, exchanges between mutual funds, capital gain distributions, and dividend reinvestments are not taxed. However, if you start withdrawing from your retirement account, you’re subject to taxes and other penalties, assuming you have not reached age 59 ½. This is because early withdrawals are taxed as ordinary income, and the penalties are significant.
Outside of retirement accounts, one opportunity for deferral and reduction of capital gains is to invest them in Qualified Opportunity Zones, which were created by the Tax Cuts and Jobs Act of 2017. The complex rules warrant discussion with a knowledgeable advisor, and some potential benefits have expired, but deferral and elimination of gains are still achievable for some investors.
Selling real estate can trigger recognition of capital gains
Suppose an investor wants to sell a specific property and buy another one to replace it. In that case, there is an advantage in retaining and using any increase in value rather than paying a capital gains tax. It is often possible to accomplish this goal by executing a 1031 exchange. The transaction is named for the relevant section of the Internal Revenue Code. It allows taxpayers to defer payment of capital gains if they reinvest profits from selling an investment property into a like-kind asset.
The IRS closely regulates the process to ensure that the investor does not have access to the funds generated from the sale of the first (relinquished) property before purchasing the replacement property. Therefore, a Qualified Intermediary must administer the transaction, and that individual or firm must ensure that the funds are held in a separate account. The QI also oversees the identification of replacement property options and manages the documentation.
Defer capital gains in conjunction with estate planning
An investor can employ the 1031 exchange strategy sequentially if desired. Each time an investor sells a property, the deferral of capital gains and depreciation adds up, so if a sale is consummated at some point without completion of a 1031 exchange, the accumulated deferrals will be due. The exception to this is if the investor continues deferring until their death. At that time, the heir receives the property with a step-up in basis that includes any deferred gains. At that point, no capital gains taxes are levied.
Whether you're trying to reduce or defer your capital gains tax liability, capital gains aren't recognized until the asset is sold. So your best defense as an investor is to invest long-term. But, again, working with a financial advisor and tax specialist is your best option to develop a strategy and to work towards your investment goals.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.